An HMRC tax investigation is not something you’d want to ever go through. It can be a very stressful time, but they’re also expensive and time consuming.

But what does it mean? What happens when you are the subject of an enquiry? And what are the chances of being chosen?

In this post we’ll look at what it means for a Sole Trader. Many of the implications are similar for other business types, but if you’ve got any concerns around how an enquiry may affect you, please get in touch.

If you’re a sole trader and facing an enquiry, you’ll need to provide up to seven years of paperwork to account for all of your business expenses. These can be in electronic format or as physical copies. Electronic copies can often be far easier to manage, so don’t feel that you have to keep the hard copies. Electronic copies don’t fade, aren’t affected by events like a water leak or go missing (if you have the right tech set-up!). 

Unfortunately, you can never completely eliminate the risk of an enquiry, as HMRC do randomly select a number of taxpayers every year. There are ways though that you can reduce the risk.

As well as keeping records for the last seven years worth of expenses, there are a number of ‘red flags’ that can make you more likely to become the subject of unwanted HMRC attention. Let’s take a look at some of them…

1. HMRC gets a tip-off

Why would somebody tip off HMRC about someone else’s finances?

The most common reasons are:

• Unhappy or jealous acquaintances who may suspect dubious activity.
• The existence of a cash-only policy at your business.
• Living a lifestyle beyond your apparent means.

Make sure you don’t get your business involved in any dodgy deals, or anything suspicious; the risks aren’t worth it. 

2. Regular mistakes on Returns

Making a mistake once on your Tax Return is nothing to worry about. They happen and HMRC understands not everyone is a tax expert. If you regularly make mistakes on your returns though, submitting inaccurate figures or information year after year will make HMRC suspicious. 

If you make mistakes two years in a row, getting help from an accountant will make sure things will go smoothly from then on – or, if you already have one and there’s not a justifiable reason for the errors, replace your existing accountant!

3. Numbers fluctuate by large margins

Excluding the impact of a global pandemic, it’s uncommon for businesses to have large fluctuations in their accounts from year to year. 

If your profits drop from £15,000 to £3,000 from one year to the next, though there may well be a very reasonable explanation, HMRC is going to notice.

Informing them of the reason as part of the notes section of your Return will reduce the chances of prompting the extra interest. Simply explaining the reason, for example something like a prolonged period of illness and subsequent reduction in your working hours will suffice.  

4. Years of unprofitability

If you’ve been in business for years, but haven’t made a profit, it may be that you’ve had investment to support you, or that a family member is paying your living costs. 

If this applies to you, let HMRC know, or they’ll soon be wondering how you’re financing your living expenses whilst making consistent losses. 

5. Your figures are inconsistent with industry standards

For most industries, HMRC generally has a pretty good idea of what you should be earning. For example, it knows a local gardener is unlikely to be earning £500,000 a year. 

It compares the latest trends and patterns in particular business or professions and evaluates it against other available information. If your accounts vary dramatically from the industry standard an HMRC tax investigation is likely. Again, communication is key, so if you’ve suddenly found a way to disrupt your industry and significantly increase your earnings, include the details on the notes section of your next Self Assessment Return. 

6. Omission of income

If your affairs involve any transactions with other businesses, HMRC will see the other end of them and may well pick up on any omissions from your records. 

For example, not declaring interest from a bank or building society account, or a dividend from shares you hold, is very likely to prompt questions from HMRC.  

It’s vital to declare ALL your income sources.

7. You don’t have an Accountant

It’s always a good idea to have an accountant to double check your records and ensure your Return is accurate. HMRC doesn’t expect you to be an expert on tax, but the central principle of Self Assessment is that the Taxpayer has to submit accurate information. The risk comes when HMRC feel that hasn’t happened, and then want to verify the quality of all your records, to check what else may have been missed. 

Having an accountant boosts your credibility with HMRC and reduces your chances of being investigated. If you’re randomly selected for any form of enquiry, your Accountant can restrict that to the area originally opened, if it’s possible, rather than it escalating through a lack of experience if you attempt to deal with it yourself. 

Additionally, a fee protection scheme offered by most firms can cover the costs of their time in dealing with HMRC on your behalf, meaning there’s less stress for you and no unexpected costs either.

The majority of these ‘red flags’ are pretty straight forward, but if any of them feel too familiar for comfort, now’s the time to get them sorted out. If you’ve not had any unwanted attention from HMRC, it’s only a matter of time!

If you’re a client of ours, please refer any communication from HMRC straight to us and we’ll handle it on your behalf.